Laurier prof says high-frequency trading controversy overblown

WATERLOO — The allegation roiling Wall Street that high-frequency trading buys an unfair edge in the stock market is not supported by most academic research on the subject, says a Wilfrid Laurier University professor.

Andriy Shkilko, a newly appointed Canada research chair in financial markets, said there is an overwhelming body of research already available that contradicts much of what has been said south of the border about high-frequency trading.

"There are some excesses, there are some things regulation may have to work out," Shkilko said. "But the net effect of high-frequency trading, keeping in mind it's only been around for about five years, has mostly been positive."

In Canada, as many as 40 per cent of the transactions executed on stock exchanges are high-frequency trades, where computers, fibre optic cables and algorithms allow traders to buy and sell tens of millions of dollars worth of various stocks in microseconds.

Armed with an infusion of about $700,000 in provincial and federal research money, the last of which was announced April 4, Shkilko plans to research high-frequency trading in Canada.

The practice has been the subject of intense scrutiny since late March, when a Canadian-born, Laurier-educated investment banker named Brad Katsuyama and author Michael Lewis alleged that some high-frequency traders were quietly purchasing ever more powerful computers and trading terminals to gain a small but valuable time advantage on everyone else in the market.

Lewis contends in his book Flash Boys that this technology allows certain traders to execute transactions before those without the technology can react.

"I was talking to someone the other day, and he said 'Michael Lewis says the markets are rigged, do you think the markets are rigged' " Shkilko said. "But this question doesn't have a straight answer."

Shkilko said the research he and others have completed suggests high-frequency trading helps the little guy. And if regulatory fixes are needed for the sake of fairness, they're quite small.

But in last week's 60 Minutes television show on Katsuyama and Lewis's Flash Boys book, it appeared as if the issue was cut and dry, said Shkilko.

In the episode, Lewis and Katsuyama detailed how they suspect high-frequency traders can "front-run" the rest of the market with the split-second time advantage provided by advanced technology.

It allows them to trade stocks at a price the rest of the marketplace isn't even aware of yet.

"There's a lot of yelling about this on TV channels," Shkilko said, but he stressed that this has never been proven in a published academic study. "The other side (in favour of computer-assisted, high-frequency trading) is supported by a vast amount of academic research done on this issue."

Shkilko said research on high-frequency trading indicates the practice as a whole makes stock markets more efficient, and reduces trading costs.

In other highly publicized cases, high-frequency traders can develop algorithms that over time predict when their competitors will buy and sell stock, and what stock they will buy.

It would take more money than any government has made available for research to allow an academic to replicate the hardware and software needed to perform high-frequency trades.

So Shkilko and his team will instead analyze raw Canadian trading data, looking to see if securities regulators in Canadian provinces need to enact more rules regarding high-frequency trading.

Previous studies at Laurier and in the United States focused on how changes to securities regulation affected high-frequency trading.

One study found that a 2011 regulatory change in the U.S. reduced the trading activity of some smaller high-frequency trading firms, but did not affect the larger ones.

"What we found is that markets got better," Shkilko said. "But we'd never say in a study that we found small high-frequency traders were bad. You could just say that since large, high-frequency traders weren't affected by the regulation, but small ones were, make your own conclusions."

Despite the controversy in the U.S. over high-frequency trading, Shkilko said nobody should yank their RRSPs out of the stock market.

"As a guy who looks at this stuff every day, I don't feel I need to withdraw my money, neither do I feel I need to stop putting my money in. But are we perfectly clear that all of this is good? I wouldn't go that far."